Project Contract Types

Manish Sharma

Last updated March 16, 2017

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If an organization decides to “buy” from one or more outside sources, it must select the type of contract it needs. In selecting what type of contract to use, the primary objective is to have risk distributed between the buyer and seller so that both parties have motivation and incentives for meeting the contract goal.The following factors may influence the type of contract selected:

Type and complexity of requirement.

Extent of price competition.

Cost and price analysis.

Urgency of requirement or performance period.

Frequency of expected changes.

Industry standards of types of contracts used.

Whether or not there is a well-defined statement of work.

Overall degree of cost and schedule risk

Types of Contracts There are generally 3 types of bilateral (signed by 2 parties) contracts:

Cost reimbursable ( or Cost Plus )

Fixed price

Time and Material contracts.

Cost reimbursable (or Cost Plus)Cost reimbursable (CR) contracts involve payment based on sellers’ actual costs as well as a fee or incentive for meeting or exceeding project objectives. Therefore, the buyer bears the highest cost risk. Common forms of cost reimbursable contracts include:

a)Costs plus fixed fee (CPFF) or Cost Plus Percentage of Costs (CPPC) means buyer will pay the seller back for the costs involved in doing the project work, plus an agreed amount (or fixed fee) that buyer will pay on top of that. If this agreed amount or fixed fee is calculated as percentage of the initial estimated project costs it is referred as CPPC type of contract. This fee does not change with seller’s performance. However fee amount can change if the project scope changes.

b)Costs plus incentive fee (CPIF) means buyer will reimburse the costs of the project and pay a pre determined fee (e.g. bonus) if seller meets certain performance goals or any other specific performance target as decided in the contract. In CPIF if the final costs are less or more than the original estimated costs, then both the buyer and seller will share the costs based on pre negotiated sharing formula.

c)Costs plus award fee (CPAF) is similar to the CPFF contract, except that instead of paying a fee on top of the costs, buyer agrees to pay a fee based on the buyer’s evaluation of the seller’s performance.

Fixed Price Contracts Fixed price (FP) contracts (also called lump-sum contracts) involve a predetermined fixed price for the product and are used when the product is well defined. Therefore, the seller bears a higher burden of the cost risk than the buyer. There are 3 types of contracts in this category:

a)Firm Fixed Price (FFP) means that buyer will going to pay one amount regardless of how much it costs the contractor to do the work. A fixed price contract only makes sense in cases where the scope is very well known. If there are any changes to the amount of work to be done the seller doesn’t get paid any more to do it, unless the scope of the work changes.

b)Fixed price plus incentive fee (FPIF) is a complex type of contract in which the seller bears a higher burden of risk. There is a financial incentive tied for achieving agreed metrics. Typically such financial incentives are related to cost, schedule or technical performance of the seller. Performance targets are established at the outset of the project and final contract price is decided after completion of the project based on the seller’s performance. For every dollar saved by the seller which reduces the cost below the original estimated target, the cost savings are split between the seller and buyer based on a share ratio (similar to CPIF). In case the cost exceeds there is a price ceiling, and all costs above the ceiling are the responsibility of the seller, therefore if costs exceed the ceiling, the seller receives no profit.

c)Fixed Price Economic Price Adjustment (FPEPA) is a fixed price contract which allow for price increases if the contract is for multiple years. It is a fixed price contract but with a special provision allowing for pre defined final adjustments to the project contract price due to change conditions, such as inflation, cost increases ( or decrease) due to specific commodities. The FPEPA is intended to protect both buyer and seller from external conditions beyond their control.

Time and Material Contracts Time and material (T&M) contracts (sometimes called Unit Price Contracts) contain characteristics of both fixed price and cost reimbursable contracts and are generally used for small project cost amounts. These contracts may be priced on a per-hour or per-item basis (fixed price) but the total number of hours or items is not determined (open-ended cost type arrangements like CR contracts). T&M contracts are often used for staff augmentation, acquisition of experts and any outside support, when a precise statement of work cannot be quickly prescribed. A Purchase Order is a simple form of unit price contract that is often used for buying commodities. It is a unilateral contract and only signed by 1 party instead of the above bilateral contracts that are signed by both parties.

Few Tips: -

Contract Type

Priorities ( Least to Important )

CPFF

Cost, Time, Performance

CPAF

Cost, Time, Performance

CPIF

Time, Performance, Cost

T&M

Performance, Time, Cost

FPIF

Time, Performance, Cost

FP

Cost, Time, Performance

Buyers’ cost risk from the various contract types (from highest to lowest):

CPPC --> CPFF -->CPAF --> CPIF -->T&M -->FPEPA ---> FPIF --> FFP

The seller’s risk is just the reverse of above sequence of contract type.Therefore whenever you negotiate a contract, you should always make sure both the buyer and seller are comfortable and satisfied with the contract type and other terms and conditions of the contract to achieve smooth and successful deliverly of the project work.

About the Author

Manish is a PMP certified professional with more than 7 years of IT industry experience in various technical and cross functional roles. He holds an M.B.A (International Business and Finance) and B.E. (Hon’s in Electronics and Communication Engineering) degrees.